FINANCIAL COMPASS: Key investment issues for 2015
You might expect that geo-political issues might be very important for 2015. Hey! It could be Iraq or Iran (who can tell the difference, even if you watch CNN?) or Ukraine or Russia or even perhaps some place on nobody’s list. Somehow I doubt if any of this will be all that important to investors. They’re really important for people who live in conflict regions but I think not so much if we are on the opposite side of the globe. In my opinion, the stock market has certainly largely ignored all of the recent hot spots so far.
My opinion is that macroeconomics forces will have a larger effect on investments. The most significant force today is deflation as discussed in last month’s column. (Call to request a copy). There are effects of deflation, a general decline in the prices of goods and services, that investors can capitalize on for profits.
The most obvious is that interest rates fall. There is a big “BUT”, but not on everything. I believe the highest quality fixed income investments are likely beneficiaries. You may have read about investment professionals who are predicting a return of inflation and higher interest rates. Sometimes projections don’t always come true. Interest rates are much lower in Japan and Germany for example, so why not here? Long term treasury bonds may be appropriate if you are of the opinion that interest rates can continue to fall.
No outlook would be complete this year without a discussion about oil prices (under $50 today as this is written). Is this good or bad for our economy? Short term it’s all good. Saving money on heating and gasoline is a great thing for consumers. Prices on goods which have a significant oil cost input will fall much slower as competition might require. The common belief is that it is the equivalent of a tax cut for consumers. I’m not so sure about that, as a tax cut could be much more permanent in nature. The oil price drop can be viewed as possibly transitory or short term. This will likely effect (Praxeology) the way consumers react to the savings from an economic point of view.
The overlooked aspect of low oil prices is its delayed effect on energy investment. Already there have been many announcements about cutbacks and delays (eventual cancelation) in energy exploration and infrastructure. The effect takes time to sink in. It will have a likely wide ranging negative influence on employment especially that which is directly involved in oil production. It will affect their suppliers and the supplier’s suppliers and so on. The overall GDP type statistics, should low prices stick around, (which I believe is very likely) will be better near term and lower later this year, probably outweighing the short term positives in my opinion.
This brings me to oil’s possible effects on junk bonds. As much as 30 percent of junk bonds are oil related according to Motley Fool.com. That might be a little high, but when cash flows evaporate due to low oil (or other commodity) prices, it’s not just expansion plans that disappear. There is considerable debt dependent on high oil prices. As the likelihood of default grows, prices of low rated debt will fall. Bond trading inventories are much lower. According to Ben Eisen at Market-Watch, (Mile Wide Inch Deep) bond inventories which were 4 percent of all corporate debt in 2008 are now only ½ percent. Liquidity could be a significant problem (opportunity) at some point this year.
Just as there are opportunities to be uncovered by watching the direction of yield differences (spreads) on junk versus treasury bonds, it often pays to watch the phenomena play out in other markets. As pointed out by Jeff Gundlach founder of Doubleline Capital, as quoted in Barron’s first issue in January 2015, a similar divergence has been developing in Italian, Grecian and Spanish debt versus German debt. Is a flight to safety beginning in Europe?…could be.
The common knowledge used to be that the U.S. dollar which had declined from its peaks in 1985 and 2002, was sure to continue its long term decline. As you might suspect, just as the crowd becomes overwhelmingly confident in “the common knowledge”, it’s about time that something else might happen. Recently the dollar index, a general measure of the value of the dollar against other major currencies, has risen from around 80 to about 90. The part generally not appreciated is that this might be only a good start. After all, as seen in charts from Worden, the 2002 peak was about 124 and the 1985 peak was about 165. What effect does a strong dollar have on particular investments? Well, for one I don’t see a strong correlation with precious metals. If the dollar is stronger, then other currencies must be weak. If it is strong due to a perception as a safe haven, then it will not necessarily require higher U.S. interest rates to attract foreign money. The ultimate safe haven has always been U.S. Treasuries.
Here are a few more strong dollar observations. A very large number of emerging market countries borrow in dollars. A significant amount of liquidity (cheap money) created by the FED (also Europe) has flowed to emerging markets debt to capture higher yields. It is well known that emerging countries are often dependent on sales of oil or other commodities to service their debt. They are also subject to infrastructure project cancelation as well. The stronger the dollar against emerging market currencies, the more expensive it becomes for the debtor to service their obligations. There are investments that can capitalize on these trends.**
How about the stock market? With the declines in oil and raw material commodities to the approximate 2009 low, it should be evident that all is not right with world economies. Every stock market drop is met with central bank money printing or the promise thereof. Worth noting is that the effect seems to be diminishing. To stimulate the economy Keynesian central bankers either print money or lower interest rates. So, when money printing stops working and interest rates are near zero or actually negative…then what? Just a guess, but before the last chapter is written, I think that central banks will be “vilified” not “deified” as they are today.
Opportunities exist to make money in 2015. It just may not be in the places where most people are looking.
*High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
**Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed
Best wishes for a prosperous 2015.
Donald Hutchinson lives in Milford, Ct. Safe Harbor Financial Management Questions may be answered by calling 203-301-0133. Securities offered through LPL Financial, Member FINRA/SIPC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor before investing. Investing involves risks including the loss of principal. All indices are unmanaged and may not be invested into directly.